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CFA Level I · CFA Level I Exam

Benchmarking Returns for CFA Level I

Benchmarking returns means measuring a portfolio's performance against a reference portfolio that reflects its mandate. Active return equals portfolio return minus benchmark return. To solve questions, pick the right benchmark, check it meets the valid-benchmark qualities, compute both returns over the same period, then subtract.

What this chapter covers

This chapter teaches you how to judge whether a portfolio did well. A raw return of 8% means little on its own. If the market segment the manager works in returned 11%, the manager lost value. If it returned 4%, the manager added value. The benchmark supplies that yardstick.

You will learn the main types of benchmarks, such as broad market indexes, style indexes, factor-based benchmarks, custom benchmarks and peer-group comparisons. You will learn what makes a benchmark valid. It should be unambiguous, investable, measurable, appropriate, reflective of current investment opinions, specified in advance, and accountable (the manager accepts the benchmark as the yardstick for their performance). You will then see how indexes are built and weighted, and how to compute benchmark and active returns.

The chapter links to several other areas. Index weighting ties to Equities and Fixed Income, where you meet market-cap, price and equal weighting and the behaviour of bond indexes. Return calculations tie to Quantitative Methods. Active return and mandate fit tie to Portfolio Construction. Fair performance reporting also touches the Ethical and Professional Standards, which cover fair representation of results. Treat this chapter as a set of short, connected ideas rather than one long topic.

Questions here are usually short and rule-based, which makes them good value under time pressure of about 90 seconds per question. You get marks from definitions, from spotting which benchmark quality is violated in a scenario, and from simple arithmetic such as active return or index weights. With three options and no penalty for wrong answers, a clear grasp of the qualities and weighting effects lets you eliminate two options quickly. The ideas also support later topics, so the effort pays off across the paper.

Benchmarking Returns: topics in the order to study them

  1. 1Purpose and Types of BenchmarksStart with why benchmarks exist and what kinds there are, because every later topic builds on this vocabulary.
  2. 2Qualities of a Valid BenchmarkNext, learn the test a benchmark must pass, since pitfalls questions are mostly about failing one of these qualities.
  3. 3Index Construction and Weighting MethodsOnce you know what a benchmark should be, learn how indexes are actually built and how weighting changes what they hold.
  4. 4Calculating Benchmark and Active ReturnsDo the calculations after the concepts, so you know which weights and returns to feed into the formulas.
  5. 5Benchmark Selection and Common PitfallsFinish by applying everything to scenarios, choosing a benchmark and spotting its flaws.

How to prepare Benchmarking Returns

Aim for understanding first, then speed. The chapter is compact, so you can finish it in a few short sessions, which suits study on a phone between work tasks.

  1. Read the purpose and types of benchmarks once and write a one-line description of each type in your own words.
  2. Memorise the seven qualities of a valid benchmark as a list, then test yourself by inventing a flawed benchmark and naming which quality it breaks.
  3. Work through index weighting by building a small three-security index by hand under price, equal and market-cap weighting, and note how each reacts to a price rise.
  4. Practise the calculations: benchmark return as the weighted sum of component returns, and active return as portfolio return minus benchmark return. Use the same period and the same currency for both.
  5. Do scenario questions on selecting a benchmark for a stated mandate, and say aloud why two options are wrong before choosing the answer.
  6. Finish with a timed set of standalone three-option questions, then review every miss and log whether it was a concept, a calculation or a reading error.

Common mistakes in Benchmarking Returns

  • Choosing a broad market index for a specialised mandate.

    Fix: Read the mandate first and match the benchmark to its asset class, style, region and size.

  • Mixing up the qualities of a valid benchmark or forgetting some of them.

    Fix: Practise with flawed-benchmark examples and name the exact quality broken each time.

  • Assuming price weighting reflects company size.

    Fix: Remember that price weighting uses share price only, so a high-priced small company can dominate.

  • Computing active return with returns from different periods or currencies.

    Fix: Confirm period, currency and income treatment match before subtracting.

  • Treating positive active return as proof of skill.

    Fix: Remember that the benchmark may be poor, or extra risk may have been taken, so ask whether the comparison is fair.

  • Ignoring that a benchmark chosen after the fact is flawed.

    Fix: Look for hints that the benchmark was picked or changed once results were known, and mark it as not specified in advance.

Last-day revision: Benchmarking Returns

  • A benchmark is a reference portfolio used to judge performance against a mandate.
  • Active return = portfolio return − benchmark return, over the same period.
  • Benchmark return = Σ (weight × component return).
  • A valid benchmark is specified in advance, so it is not chosen after results are known.
  • Check the seven qualities: unambiguous, investable, measurable, appropriate, reflective of current investment opinions, specified in advance, and accountable (the manager accepts the benchmark as the yardstick for their performance).
  • Market-cap weighting gives larger companies larger weights and adjusts naturally as prices move.
  • Price weighting depends on share price, so a high-priced stock has more influence regardless of company size.
  • Equal weighting gives each security the same starting weight and needs rebalancing to stay equal.
  • A benchmark must fit the mandate: a small-cap manager should not be judged against a large-cap index.
  • Peer-group comparisons can suffer from survivorship bias and different mandates.
  • Compare returns on a like-for-like basis: same currency, same period, same treatment of income.
  • Positive active return means outperformance, but it says nothing alone about risk taken.

Benchmarking Returns practice questions

Benchmarking Returns in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Benchmarking Returns: frequently asked questions

What is the most important formula in benchmarking returns?

Active return = portfolio return − benchmark return. The benchmark return itself is the weighted sum of its components' returns. Make sure both returns cover the same period and currency.

Do I need a calculator for this chapter?

Only for simple arithmetic, such as weighted returns or index values. Percentages can usually be handled by hand, but you may use your approved TI BA II Plus or HP 12C to avoid slips.

How are questions on this chapter usually framed?

Most are standalone three-option items. They ask you to identify a benchmark type, spot which quality of a valid benchmark is violated, compare weighting methods, or compute an active return.

Is there a minimum score needed in this topic to pass?

No. There is no minimum passing score per topic. The overall Minimum Passing Score for Level I is 1600 on the scale, so strong areas can offset weaker ones.